Oil Industry Profits

Washington Post business columnist Steven Pearlstein was online to discuss his latest column , a look at rising oil and gas prices and oil company profits.

A transcript follows.

About Pearlstein : Steven Pearlstein writes about business and the economy for The Washington Post. His journalism career includes editing roles at The Post and Inc. magazine. He was founding publisher and editor of The Boston Observer, a monthly journal of liberal opinion. He got his start in journalism reporting for two New Hampshire newspapers -- the Concord Monitor and the Foster's Daily Democrat. Pearlstein has also worked as a television news reporter and a congressional staffer.

His column archive is online here

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Fairfax, VA: Why do gas prices seem to always go up in leaps and when they go down, it seems grudgingly a cent at a time? How much of a cutback would be necessary this time to have an effect on what is described as a tight market? In any other industry when your "raw material" escalates in price, it is almost always a sign of trouble ahead with layoffs and reorganization, but in the oil industry it is a time of glee?

Steven Pearlstein: Lots of questions there. Gas prices normally do fluctuate in pennies. The recent jumps mostly reflect the real tight supply of refined products (gasoline) and the rapid rise in the futures price of crude oil, which the companies use as a benchmark in their current pricing. The rule of thumb is that every dollar increase in the price of crude results in a 5 cent increase in gasoline gallon. So we've had a $15 increase in the price of crude over the last two months, so you'd expect more than a $1 increase in gas before this is all over.

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Bethesda, MD: Mr. Pearlstein: one radical way that consumers can "stick it to the oil companies" is to (gasp) buy a more fuel efficient car. I wonder how many of your readers are aware that there are fairly large federal tax -credits- (not deductions) in 2006 for buying a high-mileage vehicle. For instance on the Prius I just purchased, I am slated to get $3,150 back on my federal return next year.

Steven Pearlstein: If they read the Washington Post, or washingtonpost.com., they should be aware of that. Obviously, fuel efficiency is something we've neglected over the last decade, when the fuel efficiency of the typical car hasn't changed at all. It is too bad the oil companies supported the car companies in opposing more stingent fuel economy standards. It was a real mistake economically and environmentally. The oil companies have now changed their tune, but its a bit after the horse is out of the barn.

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Vienna, VA: With Iran's threats regarding nuclear technolog and oil, the world seems to be taken hostage by oil. It is such a shame that the U.S. has become dependent on oil like a drug. I don't know what the solution is to the oil addiction that our country has, but without real leadership and sacrifices, we are doomed to be held hostage by oil producing country like Iran. Both republican and democrat parties ought to be ashamed that more politics are taking place in Washington than building a more secure nation that is free from foreign oil. Perhaps like Rome, the U.S. has already reached it's peak of greatness?

Steven Pearlstein: All good comments and questions.

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Clifton, VA: If we are going to have a windfall profits tax on oil companies we should also have the same tax on any company's whose profits are higher than the average. Oil company profits are not that high as a percentage or in comparison to other industries. Sen. Feinstein needs to shut her socialist mouth and come up with a new 5 year plan. Problem is a lack of refinery capacity which can be blamed on low oil prices and environmental regs. Let the market place rule. The gov't needs to stay out of it. And if we are going after anybody lets go after George Soros who has used the oil and energy futures market to try to get an advantage for the Dems and his comrades.

Steven Pearlstein: I'm with you on the windfall profits tax: probably not a good idea, for all sorts of reasons, including the games playing it would generate on the part of the oil companies and their tax accountants. But we should be careful about talking about the oil and gas markets as if they were really free markets. They're not. Most of the world's oil is controlled by government-owned oil monopolies, which conspire with each other to fix the world price. The downstream market has become highly concentrated, which gives way to oligopolistic behavior, as we have witnessed in many regions of the country. The government has all sorts of incentives it gives the industry, and sets royalties for publicly owned oil and gas. There are import restrictions. Etc. Etc. So let's acknowledge that this isn't a market like the market for copper or toilet paper, and deal with that reality. That doesn't mean reregulating the industry the way we used to. But it may mean having government take a more active role, which Bush sort of acknowledged in his talk yesterday.

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Mt. Vernon, IL: I would just like to know why everyone seems to immediately think of the local gas station operator when the term "price gouging" is spoken instead of turning to the oil companies who have enjoyed a 200% plus increase in profits over the last few years while consumers are suffering and why President Bush seems compelled to ease environmental regulations to get cheaper fuel for the consumer instead of calling for an investigation into the oil companies outlandish profits.

Steven Pearlstein: I don't think people really do blame the dealers. They know their local dealers, they know they don't live high off the hog, that they work hard and often get their hands dirty. I also wish we could stop the use of the word gouging. Gouging is not what's going on here. What's going on is that very powerful interests have tried to manipulate supply, which in the context of a market economy, has a long run impact on price. That's price fixing, not gouging.

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Pleasantville, NY: I presume the big international oil companies have to pay the current $70+ prices per barrel for oil they don't own, and that, therefore, the profits they derive from such oil are fairly modest, limited to what they can get from adding value through refining and marketing. I also presume that they get extremely high profits, probably the vast majority of those they report, from their owned reserves. While these reserves are dwindling and far smaller than those owned by the major producing nations, they remain substantial, are carried on the companies' balance sheets at a very low cost, and, on average, are extractable at costs that are a small fraction of the current market price for a barrel of oil. Is this a correct view?

Steven Pearlstein: Well, you are right about the big profits on pumping oil that the big companies own or have controlled for a long time. But the relationship with the countries that own most of the world's supply of crude are complex. They don't merely pay the world spot price and get a fee for pumping. The arrangements, which are highly secret, vary. They involve some cost sharing, some profit sharing, perhaps pegged to an initial reference price. But it is clear from their upstream profits that the oil companies certainly enjoy considerable "upside" benefit when the price of crude increases. They are not just contract drillers and pumpers.

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Arlington, VA: Steven,

There is no normal, there is only reality. The reality is that we have spent the last 60 years and a considerable amount of resources building a society of the like that has never been seen in all of human history. It is a society based around the consumption of large ratios of a resource that was 'discovered' about 150 years ago (Colonel Drake drilled the first well in the US in 1859). For most people, there is no choice but to consume large amounts of fossil fuel based energy in order to survive. This has allowed us to obtain a standard of living in terms of material goods never before seen. This is due to petroleum being such an enormously valuable find (the result of millions of years of concentrated sun energy). Our depletion rate (use) of this has grown (doubled in most cases) every decade as population grows and we fling more and more of our settlement patterns further away from destinations and houses get bigger etc. Well, we are now faced with the time when supplies will likely no longer be able to increase (google peak oil). Whether this is now or 5 or 10 years from now doesn't really matter. Can an economist grasp the consequences of this ? Do some actual research and discover for yourself. Good luck to you.

Steven Pearlstein: What is it with you peak oil people. Its like scientology. Its a wonderful theory that the world is about to run out of oil, and it may be true. But the certainty with which you state your opinion, when it is so obvious that you are talking about a subject about which NOBODY can be so certain, raises lots of question about your credibility.

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Charlotte, North Carolina: Dear Mr. Pearlstein:

I am a naturalized American citizen originally from Iran. I came to these United States in 1970 and have traveled back to my native country numerous times. When monarchy ruled Iran it was the Shah who orchestrated the greatest price increase for a barrel of crude by manipulating OPEC membership. Now it is the mullahs doing the same under strict order from the likes of British Petroleum, Exxon/Mobil, Occidental, Statoil, and ......... All you have to do to verify existence of this clandestine partnership between shiites mullahs and their Western masters (British in particular), is study recent Iranian history since 1950's. Do you not agree?

Respectfully submitted;

Kamran

Steven Pearlstein: I think there is tacit collusion between OPEC member companies and the multinational oil companies, because their interests, broadly speaking, are pretty well aligned and they have lots of dealings with each others, as partners and customers and suppliers and trading partners. But at this point, I think it is the national oil companies and national governments that are mostly calling the shots, not the oil companies. If you doubt that, look at what is happening in Venezuela now, where the leftist government is effectively renationalizing the industry because it doesn't like having to share so much of the windfall profits with its oil company partners.

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Arlington, Texas: Is it true that we in the US pay the most for a gallon of gasoline. I do not mean the "price at the pump" BS that big oil keeps telling us about. I mean the price after taxes are subtracted. I.E. in the US gasoline is $3.00 less $.40 taxes makes the price of gasoline $2.60. The Netherlands is $6.75 less $5.25 taxes equals $1.50.

If the US were to eliminate the federal income tax and put a $10.00 per gallon tax on gasoline, I would be OK with paying $12.00 a gallon at the pump.

Steven Pearlstein: I'm not sure I'd go that far, but yes, it would probably be better for consumers, and worse for oil companies, if the federal fuels tax was increased and rebated to consumers in some fair fashion.

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Detroit, MI: How can the boards of directors of Exxon-Mobil and others, in good conscience, approve such unbelievably obscene compensation packages to their CEOs, CFOs, etc.?

Steven Pearlstein: The obscene part of the packages usually has to do with stock and stock options and long-term compensation tied to company performance. Some of that is deserved. But a lot of it is just dumb luck having to do with the price of oil and gasoline, which no chief executive is responsible for (although collectively, they do affect). There is simply no common-sense, moral warning signal that directors use that goes off when compensation exceeds, say, $5 or $6 million a year -- that says, "Are you sure its a good thing to pay anyone this amount. Isn't there somebody out there who is nearly as good, or just as good, who would do this job for less?" That's what happens when they hire security guards or software engineers. But not, it seems, CEOs.

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Denison, TX: I understand that during the CA energy crisis, there was collusion among Enron functionaries to create a shortage. As refineries are involved deeply in the 'shortage' of gasoline, doesn't it look as if there is manipulation of the functioning of our domestic refineries involved in making that shortage?

Steven Pearlstein: I'm sure they are pretty careful right now about an overt manipulation, which was possible in the CA energy crisis because of the daily bidding system set up by the state, which practically invited that kind of behavior. The market for refined gas is different. But you do have to wonder why it has taken so long to get some Katrina-damaged facilities up and running, and whether there is much of an incentive to do so if holding back supply can have such a dramatic effect on price. One does notice, for example, that the crack spread, or the spread between crude oil and the equivalent price of a galon of gasoline, is now over 50 cents (its normally about 20 cents). That tells us that crude prices aren't the only thing driving gas prices. The refinery shortage is now as much, or greater, part of the problem.

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Columbus OH: Instead of blaming Exxon for making money selling oil, a fast-depleting non-renewable resource, why aren't you talking about the real problem: global oil production is at it's peak and will go into decline in the next decade. Where is the public discussion about our future in a post-carbon world? We have nothing after oil! Hydrogen is not an energy source, it's a way to store energy, where do we get the energy?

I think it's very damaging to the public to play a blame game instead of discussing this issue! It's hurting America to feed the public this kind of pin-the-blame-on-the-someone-else. I get so disheartened at politics and media pundits whenever I see this kind of disinformation and blame tactics.

We ought to be holding a serious discussion of how we can manage our transition away from oil, this isn't going to happen with 99 cent gasoline.

So I guess my question is: why are politicians and the media so brain dead on this issue? Wake up!

Thanks for taking the time to address my deep concern.

Steven Pearlstein: Gee, our Outlook section two weeks ago had a big front-page splashy display for an essay by the founder of Greenpace about how nuclear energy ought to be high on the options list again. The President is talking about biomass and ethanol. Liberals have been talking about wind and solar for as long as I can remember. And on the facts, you are simply wrong: there is plenty of oil and gas out there to be tapped that can keep us going for decades, even as we begin shifting over to other energy sources as the price of the GRADUALLY depleting resource rises.

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Roswell, GA: Mr. Pearlstein, it doesn't appear from the Post's summary of your background that you have any business education. If the Post feels that your views are worth printing, why don't they put them on the Opinion page in the editorial section as the New York Times does with Paul Krugman?

Your column today, purporting to know the thoughts of a man you don't know who works in an industry you don't understand, is a disgrace.

Steven Pearlstein: I am an opinion columnist. We have opinion columns that appear in all of our sections, including sports and metro and food. I am sorry if that is not clearly enough labeled for you.

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Woodbridge VA: So, are you saying that the refining industry is now "coordinating" its refining capacity investment plans since it has "consolidated to a handful"? Isn't 50+ companies more than a handful?

Steven Pearlstein: In any region there are not 50+ companies. That's the industry's big lie that they include in all the talking points. There are three or four major suppliers in each region, which is the relevant market area to consider when analyzing concentrations. And they are very careful not to increase supply to the point where it will "ruin it" for everyone in the market, knowing that even modest amounts of "excess supply" in a capital intensive industry can results in big decrease in market prices for everyone in the market.

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Washington, DC: I think President Bush nailed it succinctly when he said yesterday that gas prices are rising because supply is greater than demand. Americans think mobility is their birthright but don't understand how exposed we are to the politics of some pretty unstable places and how the aspirations of China and India affect us. We are the price takers, not the price makers. I don't think either party will be able to propose legislation to lower gas prices significantly. What say you?

Steven Pearlstein: Your comment assumes that world supply is determined in a market fashion. Its not. Supply of both crude and refined products is determined, in the first instance, by a notorious price fixing cartel run by guys who learned their monopoly pricing strategies at the Harvard Business School. And in terms of refined products, it is largely determined by a handful of big companies that have recent, painful expereience in a market with excess supply, and have learned their lesson.

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Fairfax, VA: Personally, I think that the oil profits are actually a loss for the industry. Right now they are getting profits on oil that they had done exploration, production, and refining on $30 a barrel oil but they are now getting at least $60. But if they look at return on investment for new exploration, production, and refining you are going to pay about what it takes to get the oil, and the margin of profit has gone down drastically. With the large capital costs of exploration and production it doesn't make sense for the industry to continue exploring and producing if there margin is less now than it was when the oil was $30. Demand may be up but supply is relatively constant because we only have so much in reserves; if we dip too much into those reserves imagine how much the price will be when we really need those reserves for products like plastic.

Steven Pearlstein: Look, nobody is saying that oil companies don't take a big risk investing billions of dollars today for exploration and drilling knowing that oil will fetch anywhere from $30 to $100 a barrel when its time to bring it up. They deserve some sort of premium for that risk, I agree. But they have been quite careful to invest only when they think they can earn a profit that is above the cost of capital, and then some. The hurdle rates are very high. But if you assume a price of more than $50 a barrel, there is a lot of oil and gas out there that is worth drilling. That's what I mean when I say the supply is not fixed.

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Arlington, Va.: Loved the line in your column today about financial pains to consumers is payback for having to live in Houston! Now my question, if I understood your column correctly, it appears that you support a fuel tax like in Europe. I had been against this (thinking it would hurt poor people in areas without good public transportation), but am now coming around to it. But do you honestly think that will really ever happen?

washingtonpost.com: Today's Column: Using Tough Tactics to Divulge an Industry's Secrets

Steven Pearlstein: Thanks. And no, it probably won't happen now. It may happen when prices retreat, which they probably will at some point. But while the tax would be most effective when prices are already high, in reducing consumption and industry profit, it is the hardest sell politically.

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Erie, PA: Your column today is the first time I've seen anyone in the national media bring up the affect futures speculators are having on the price of crude. As I understand it from some pretty reliable financial experts, supply is in pretty good shape, and has actually been rising along with prices at the pump. Why, do you suppose, do the national media keep reporting about "tight supply" and "global unrest" as the major cause behind high gas prices, when it seems clear that the rise in the number of futures speculators are the major factor?

Steven Pearlstein: Look, all of these things are factor. But I'm hardly the first person to write about the speculative premium. This results in large part from a paper done by a couple of finance professors who showed that commodities are a good hedge against weak stock and bond markets. So now every pension fund has decided it needs to own commodities, which helps to explain why copper and gold and oil prices are now so high. It represents a one-time shift in relative prices, but it hasn't fully played itself out.

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Denver, Co: Thank you Sir, Perhaps you can provide me an insight of how do the Oil Companies calculate what their profit margin should be? Is it a percentage of the cost on a barrel of crude or a percentage of refined produced. With the "windfall" it cannot be a fixed profit amount (say .20 per gallon). So if Gas was $1.50 a year ago and is $3.00 now, the profits have doubled without increase of any costs. So what initiative do companies have to build refineries to reduce demand? I don't believe there is any coercion on the part of the Oil Co., unless it's the Execs agreeing to do nothing.

Steven Pearlstein: First, there is political risk in doing nothing. And second, if they build no new capacity, the price will get so high that they will invite switching to non-petroluem energy prices. So the trick for the monopolist is to maximize revenues and profits by keeping the price just below the point where large amounts of fuel switching occur.

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Concord, NH: Although I'm not quite adept enough with corporate finance to follow your column today, it did pique my interest on one topic. Is there something about the retail gasoline market that makes "loss leader" type attempts to grab market share unworkable? Why doesn't Walmart just subsidize Sam's Club's gas sales until the local big oil franchises fold and then jack up prices once Walmart has a quasi-monopoly?

Steven Pearlstein: Wal-mart tried just that thing, and has had an effect on the retail price. But Wal-Mart needs to buy its gas from someone, and that turns out to be Murphy Oil and some of the other independents, who are happy to have the business when supplies are a bit loose. But now that they are tight, you'll be seeing a squeeze on the independents at both the refining and retail level, as they are forced to bid quite high for supply, and cannot sustain their role as the low-priced supplier.

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Austin, TX: A basic question. If I'm a baker and the price of flour goes up, I have to make hard decisions about how much of the cost to pass on to my customers and how much to absorb myself (out of fear that my customers will switch to tortillas). Either way, the increase in the cost of flour is bad news for me.

But if I'm an oil company and my main ingredient (crude) increases in price, I make money hand over fist.

Why?

Steven Pearlstein: Because switching fuel for most people is not as easy as switching bread. In the long run, yes, keeping prices high run the risk of reducing demand. But in the short run, demand is said to be pretty "inelastic."

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Okemos, Michigan: When the CEOs of the oil companies testified previously, they were not sworn in. It was OK to have baseball players sworn in, why not the executives. Will they have their books open for evaluation by OMB, and testify to the facts therein?

Steven Pearlstein: Swearing in was not the problem. The problem was the Senators who love to hear the sound of their own voice, and actually think people are listening. If the Senate Committee had allowed the staff to really grill those guys, they could have really laid them on the carpet. Instead, they let them get off without a scratch.

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Math : "The rule of thumb is that every dollar increase in the price of crude results in a 5 cent increase in gasoline gallon. So we've had a $15 increase in the price of crude over the last two months, so you'd expect more than a $1 increase in gas before this is all over. " 15 x5=$0.75 We have already had $0.25 raise in prices why do you think it will still go up another $1?

Steven Pearlstein: What we don't know is the lags, so the full effects of $75 oil might not yet be built into the price.

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Naples, FL: It is easy to villainize the oil industry. All the hoopla about obscene profits is great political theater. If the profits go back to finding more oil, then what is wrong? Let me pose a different situation and I would appreciate your thoughts.

Suppose you bought a house to live in 1996 for $200,000. You sell the house 10 years later for $1,000,000. You have an $800,000 gain (Disregard tax for a moment). That is a "big" profit. Yet you still need to live somewhere. A new house is going to cost you $1,000,000. While you had a big "profit", you really are no different. You are still living in a house of same size, etc. (You do not relocate to different market)

As long as you "reinvest" the Big "profit" back into a house, I have no problem with that If you do not reinvest, then that "big profit" should be subject to windfall tax, etc.

So what is wrong with "huge" profits if they go back into finding more oil, (presumably harder to find, risk, etc.) After all, the "low hanging fruit" has already been harvested.

Steven Pearlstein: Nothing is wrong with periods of above-average profits in a highly cyclical industry. Let's be clear about that. But the profits are now at a point where they more than compensate for the risk and cost of capital to replace the oil being pumped. And that is what people find objectionable, and what economists call rents. And the ability to sustain rent-like profits is a pretty good symptom of an imperfectly competitive market.

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Arlington, VA: "NOBODY can be so certain, raises lots of question about your credibility."

Steven,

Do you believe that the US Oil production peaked in 1972 ? Do you believe that 38 of the 50 top Oil producing nations have also peaked ? It's not at all about running out. This shows that you haven't bothered to even look into this topic. Check out the DOE, US Army Corps, DoD reports on the subject before misleading people so.

Steven Pearlstein: Your analysis does not include the supply effects of a sustained price at $70 a barrel. This is NOT a static situation.

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Helena, Montana: I'm firmly in the anti-Bush camp but I thought his suggestion that Congress roll back some $2B in tax breaks for oil companies was pretty gutsy. However, it seems to gotten almost no play. Why?

Steven Pearlstein: Because its really not much, considering the tax breaks he's leaving in place.

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Fairfax, Va.: I just read the US oil companies made over $3 billion the first quarter. They haven't built a new refinery in over 20 years to limit supply. If this isn't price gouging what is?

Steven Pearlstein: Caerful. Just because they don't build new refineries doesn't mean they aren't increasing capacity. In fact, they've been getting lots more production out of existing facilities,a nd expanding them, which is a lot easier and cheaper than building a whole new refinery. But it would be good for consumers if a few new refineries were now built. The market demand is certainly there. And if it doesn't happen, you can be pretty sure it is because all the big refiners understand that their top priority ought to be to keep supplies tight. Just do the math. If a 5 percent increase in supply results in a 30 percent decrease in price, and somebody has a 35 percent market share, its not a particularly good deal to build a refinery that increases regional supply by 5 percent.

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Silver Spring, Md.: I have heard that local refining rules are one bottleneck for local gas supplies. Is Bush's recent move to loosen these local rules a step to prevent Pennsylvania from suffering a gas shortage of their own making? Aren't their refineries unable to make a change to a new formulation in time to supply the market?

Steven Pearlstein: It should help a bit, yes.

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Reston, VA: I cannot be the only person who does not understand this, I thought almost all gasoline was forward priced, or purchased on a contract. I thought very little gasoline was actually purchased on the spot market. Yet, the price transmission from the price of oil to the price of gas seems to be one of the fastest moving processes out there. Can you explain why this occurs? The price of a bag of Fritos does not go up and down every day based on the price of a bushel of corn.

I think that when you inherently do not understand the process of the pricing, you distrust it.

Steven Pearlstein: You raise a good question that I've asked before to some industry types. The answers have not been wholely satisfactory/

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Wash, DC: I have no problems with companies making profits. Especially when the government has imposed a monopoly on them by restricting them from investing their profits in growth into new infrastructure. Why can't rising gas prices be explained in a simple supply and demand equation. And what is wrong with free enterprise when a company does turn a profit.

Steven Pearlstein: Nothing, other than the fact that supply is not set in a purely free market.

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Steven Pearlstein: Sorry, folks but we're out of time. Good, lively discussion. See yo next week.

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